The following is presented for informational purposes only and is not intended as credit repair.
Debt consolidation comes in many forms. The two most popular are generally a debt consolidation loan and a debt management plan. Both can be effective ways to manage and reduce your debts, and both come with similar pros and cons. Importantly, both are likely to have an impact on your credit score.
How does debt consolidation help?
The primary benefit of any kind of debt consolidation is the fact that it combines multiple debts into a single payment. Where once you were paying off six different debts, now you have one, with a single fixed payment – presumably a payment you can afford.
Your interest rate is also affected by the consolidation. In a debt consolidation loan, you use the loan to pay off the other debts, leaving you with the new loan and its annual APR, which may be fixed or variable depending on the loan terms. In a debt management plan, you make a single payment each month, with each of your creditors receiving their agreed upon share of that payment. In exchange for using a debt management plan, most creditors provide significant interest rate reductions, which means your debts are paid off faster than they otherwise would have been.
How does debt consolidation affect your credit?
Any form of debt consolidation is likely to have a combination of both good and bad effects on your credit history. Whether or not that all adds up to a positive gain is really up to the consumer and what they do after they’ve consolidated their debt.
Should you pay off a series of credit card debts with a consolidation loan, for example, there are usually three major immediate impacts:
- Those debts are now paid in full. As you’d suspect, this is a good thing. One of the key factors in most credit scoring models is the percentage of available credit you’re currently using. Bringing your unsecured debts down to zero certainly helps. However…
- In most cases, the accounts you’re paying off with your consolidation loan must be closed. Once an account is closed, it’s no longer a factor when calculating your credit usage. In fact, if all of your credit card accounts are closed as a result, you may technically have no available credit at all, and that may negatively impact your score.
- Lastly, there’s the age of your various credit accounts to consider. It’s a smaller factor in most scoring models, but still important. Accounts that have been open for longer and are in good standing are crucial to building strong credit. Replacing many older accounts with one new account could potentially cause a dip in your score, at least in the short-term.
But here’s the most important factor to keep in mind – consolidating your debt does not make you debt-free. Consolidation is just a tool to help you repay your debts. Even in a consolidation loan, where you can see debts being repaid instantly, remember that you are – for all intents and purposes – just as in debt as you were before. The debt has simply shifted.
You have to use the consolidation to help you repay the debt. Actually repaying the debt in full and in the agreed upon manner is where all the positive progress will be made, both in terms of your debt and your credit.
So, to summarize:
- Nearly all forms of debt consolidation have the potential to help you repay your debts and improve your credit over time – you simply need to follow through by making your payments on time and in full every month.
- In the immediate aftermath of consolidating your debts, your credit may dip as your old accounts are closed and your available credit decreases. Presuming you repay your debts and use credit wisely going forward, there’s a very good chance this dip will only be temporary.
Debt consolidation can be a powerful tool if you’re struggling to repay your debts. If you’re interested, learn more about how a debt management plan may help you and whether or not debt consolidation is right for you.